Money Morning Mailbag: How the Demise of Glass-Steagall Helped Spawn the Credit Crisis

Question: Please address why the removal of the Glass-Steagall Act in 1999 caused the financial meltdown of 2007 and why its reinstatement is the only way to stop the financially risky behavior allowed after it's removal. Address why we will very likely have another meltdown (probably in 2010) unless reinstated.

Answer: Mr. Scott: While the overturning of what remained of Glass-Steagall did not cause the meltdown, it certainly contributed mightily to the systemic nature of the crisis.

Allowing commercial banks and investment banks to marry created giant operations that became too big to fail and too profitable to break up. Everyone was making money. The overriding problem was not the integration of commercial (deposit-taking and loan-making) banks with investment (capital-markets trading) banks, but the extraordinary migration of all banks into the same products, trading, and risk-taking businesses. I am definitely including the ubiquitous game of mortgage origination, securitization, sales and trading.

While it would seem prudent to separate taxpayer-backstopped commercial banks from investment-banking operations that take more risk, it's not likely to happen.

Too many interested parties have too much money to arm lobbyists to maintain Wall Street's status quo.

The so-called "Volcker Plan" to ban "proprietary trading" at institutions that take depositor funds and that are ultimately backstopped both by the Federal Deposit Insurance Corp. (FDIC) and taxpayers is a sensible plan. It has been reviled on the grounds that it is unworkable because it is impossible to define "prop" trading.

But that's just a ruse. The real reason the plan is hated is because it represents a back-door resurrection of Glass-Steagall. In order to stop prop trading at deposit-taking banks, we'd first have to separate deposit-taking banks from investment banks with trading and broker-dealer operations.

Too bad the plan has already been flattened by a frontal assault from U.S. senators Christopher J. Dodd, D-CT., and Richard Shelby, R-Ala., U.S. Rep. Barney Frank, D-Mass., and the rest of the Wall Street shills.

But the Volcker plan makes sense. The truth about proprietary trading is that it needs to be defined narrowly. If a deposit-taking institution holds risky securities or products that it intends to profit from, that's a form of trading - there's a risk involved. Not that there aren't risks involved in a bank making loans that don't get repaid. That is also a bank risk - but at least that's a risk that can be better-managed, accounted for, and provisioned for.

Banks shouldn't take inordinate risks for profit and derive executive compensation from risky trades made with taxpayer protection. That's a recipe for moral hazard on a massive scale.

If we're going to prevent another meltdown, the first thing we have to do is make sure systemic integration doesn't create another supra-trade like we saw with the subprime trade that wrecked so many banks and households.

We need to break up big banks so that they can never again endanger the functioning of capital markets or the economy. We also need to create a logarithmic capital-ratio-scaling regime to ensure that as risk increases, capital is more than plentiful to absorb losses.

[Editor's Note: Retired hedge-fund manager R. Shah Gilani has established a reputation as one of the leading experts on the global credit crisis. His savvy analyses have appeared in Money Morning and have been read by millions across the Internet. In a special report that appeared last week, Money Morning Contributing Editor Shah Gilani detailed the need to ban risky trading by banks. To check out that report, please click here.]